Current Ratio: A Measure of a Company’s Liquidity and Short-Term Solvency
The current ratio is a financial metric used to assess a company’s short-term liquidity and ability to cover its short-term obligations using its short-term assets. It’s a measure of a company’s ability to meet its short-term financial obligations, such as debts and upcoming expenses, with its short-term assets that can be easily converted into cash within a year.
Current Ratio = Current Assets / Current Liabilities
- Current Assets include assets like cash & cash equivalents (90 days), marketable securities, accounts receivable, inventory, and other assets that are expected to be converted into cash within a year.
- Current Liabilities include liabilities like accounts payable, short-term debts, and other obligations that need to be paid within a year.
A current ratio greater than 1 indicates that a company has more current assets than current liabilities, which generally suggests a good ability to meet short-term obligations. A higher current ratio is generally seen as a sign of better short-term liquidity. However, a very high current ratio might indicate that the company is not efficiently using its current assets to generate returns.
It’s important to note that the ideal current ratio can vary across industries and companies. Some industries with inventory-heavy operations might have lower current ratios due to the nature of their business cycles. Additionally, while the current ratio provides insights into short-term liquidity, it doesn’t provide a comprehensive view of a company’s overall financial health. Other financial metrics and context are also necessary to make informed judgments about a company’s financial stability.